CHAPTER 19 Pricing Concepts Lamb, Hair, McDaniel Chapter 19 Pricing Concepts 2011-2012 CHAPTER 19 Pricing Concepts Trying to set the right price is one of the most stressful and pressure-filled tasks of the marketing manager. © iStockphoto.com/ktsimage

Chapter 19 Pricing Concepts Learning Outcomes LO 1 Discuss the importance of pricing decisions to the economy and to the individual firm LO 2 List and explain a variety of pricing objectives LO 3 Explain the role of demand in price determination

Chapter 19 Pricing Concepts Learning Outcomes LO 4 Understand the concept of yield management systems LO 5 Describe cost-oriented pricing strategies LO 6 Demonstrate how the product life cycle, competition, distribution and promotion strategies, customer demands, the Internet and extranets, and perceptions of quality can affect price

The Importance of Price Chapter 19 Pricing Concepts The Importance of Price Discuss the importance of pricing decisions to the economy and to the individual firm LO1

The Importance of Price Chapter 19 Pricing Concepts The Importance of Price To the consumer... Price is the cost of something To the seller... Price is revenue Notes: Price means one thing to the consumer and another to the seller. To the consumer, the price is the cost of something; to the seller, price is the source of profits. Marketing mangers find the task of setting prices a challenge. Price allocates resources in a free-market economy 1

Chapter 19 Pricing Concepts What Is Price? Price Price is that which is given up in an exchange to acquire a good or service. Notes: Price is typically money exchanged for a good or service; however, it may include other costs such as time lost while waiting to acquire the good or service. Consumers are interested in obtaining a “reasonable price,” which means a “perceived reasonable value” at the time of the transaction. The price paid is based on the satisfaction consumers expect to receive from a product and not necessarily the satisfaction they actually receive. Price can relate to anything with perceived value, not just money. When goods or services are exchanged, the trade is called barter. 1

What is Price? Sacrifice Effect of Price Information Effect of Price Chapter 19 Pricing Concepts What is Price? Sacrifice Effect of Price What is sacrificed to get a good or service Money, Time, Dignity Information Effect of Price Infer quality information based on price Higher quality = higher price Convey status Value Based upon Perceived Satisfaction Reasonable Price = Perceived Reasonable Value Exchange based on expectation of satisfaction 1

The Importance of Price to Marketing Managers Chapter 19 Pricing Concepts The Importance of Price to Marketing Managers Revenue The price charged to customers multiplied by the number of units sold. Profit Revenue minus expenses. Notes: Prices are the key to revenues, which are the key to profits for an organization. Revenue is what pays for every activity of the company. What’s left over is profit. The price is set to earn a profit for the company. Managers strive to charge a price that will earn a fair profit. 1

Trends Influencing Price Chapter 19 Pricing Concepts Trends Influencing Price Flood of new products Increased availability of bargain-priced private and generic brands Price cutting as a strategy to maintain or regain market share Notes: Setting the right price can be a stressful task of marketing managers, as demonstrated by the above trends in the consumer market. Consumers are using the Internet to make wiser and more informed purchasing decisions. Competition in general is increasing, and consequently many installations, accessories, and parts are being marketed like indistinguishable commodities. Internet used for comparison shopping U.S. recession from late 2007 to 2009. 1

List and explain a variety of pricing objectives Chapter 19 Pricing Concepts List and explain a variety of pricing objectives LO2

Pricing Objectives Profit Oriented Sales Oriented Status Quo 2 Chapter 19 Pricing Concepts Pricing Objectives Profit Oriented Sales Oriented Status Quo Notes: Pricing objectives must be specific, attainable, and measurable to survive in today’s competitive market. Pricing objectives can be divided into the three categories shown above and described in the following slides. 2

Profit-Oriented Pricing Objectives Chapter 19 Pricing Concepts Profit-Oriented Pricing Objectives Profit-Oriented Pricing Objectives Profit Maximization Satisfactory Profits Target Return on Investment Notes: Profit-oriented pricing objectives include profit maximization, satisfactory profits, and target return on investment. A discussion of each of these follows. 2

Profit Maximization Profit Maximization Chapter 19 Pricing Concepts Profit Maximization Profit Maximization Setting prices so that total revenue is as large as possible relative to total costs. Notes: Although profit maximization aims at setting prices for a large total revenue, it does not always signify unreasonably high prices. Both price and profits depend on the competitive environment and the product’s perceived value. Remember, too, that a firm cannot charge a price higher than the product’s perceived value. Satisfactory profits represent a reasonable level of profits that is consistent with the level of risk an organization faces. 2

ROI = Net Profit after taxes Chapter 19 Pricing Concepts Return on Investment Return on Investment (ROI) Net profit after taxes divided by total assets. Notes: The most common profit objective is a target ROI, or the return on total assets. It represents a firm’s effectiveness in generating profits with the available assets. The higher the firm’s ROI, the better off the firm is. ROI puts a firm’s profits into perspective by showing profits relative to investment. ROI needs to be evaluated in terms of the competitive environment, risks in the industry, and economic conditions. In general, firms seek ROIs in the 10- to 30-percent range, depending on the industry. ROI = Net Profit after taxes Total assets 2

Sales-Oriented Pricing Objectives Chapter 19 Pricing Concepts Sales-Oriented Pricing Objectives Market Share Sales Maximization Sales-Oriented Pricing Objectives Online Target vs. Walmart vs. JC Penney Shop for some kind of electronic device (DVD player, digital camera, MP3 player, etc.) on the Target, Walmart, and JCPenney Web sites. How do the prices for the same product compare at the three retailers? Do they all even carry the same product? Compare the price on the Web with the price offered at the physical store and explain any discrepancies. Notes: Sales-oriented pricing objectives are based either on market share or on dollar or unit sales. 2

Chapter 19 Pricing Concepts Market Share Market Share A company’s product sales as a percentage of total sales for that industry. Notes: Market share can be reported in dollars or units of product, and the results may be different. Many companies believe that maintaining or increasing market share is an indicator of the effectiveness of their marketing mix. Larger market shares often mean higher profits, thanks to economies of scale, market power, and ability to compensate top-quality management. However, this conventional wisdom is not always reliable. Many companies with low market share survive if they are in a slow growth industry and experience few product changes. 2

Sales Maximization Short-term objective to maximize sales Chapter 19 Pricing Concepts Sales Maximization Short-term objective to maximize sales Ignores profits, competition, and the marketing environment May be used to sell off excess inventory Notes: Maximization of cash should never be a long-run objective because cash maximization may mean little or no profitability. Without profits, a company cannot survive. 2

Status Quo Pricing Objectives Chapter 19 Pricing Concepts Status Quo Pricing Objectives Maintain existing prices Meet competition’s Status Quo Pricing Objectives Notes: Status quo pricing seeks to maintain existing prices or to meet the competition’s prices. This category requires little planning, and is essentially a passive policy. 2

The Demand Determinant of Price Chapter 19 Pricing Concepts The Demand Determinant of Price Explain the role of demand in price determination Notes: After pricing goals are established, specific prices are set. The price set for products depend on two factors: the demand for the good and the cost to the seller for that good. LO3

The Demand Determinant of Price Chapter 19 Pricing Concepts The Demand Determinant of Price Demand The quantity of a product that will be sold in the market at various prices for a specified period. Supply The quantity of a product that will be offered to the market by a supplier at various prices for a specific period. 3

Exhibit 19.2 Demand Curve and Demand Schedule for Gourmet Cookies Chapter 19 Pricing Concepts Exhibit 19.2 Demand Curve and Demand Schedule for Gourmet Cookies Notes: The quantity of a product that people will buy depends on its price. The higher the price, the fewer goods or services consumers will demand, and vice versa. LO3

Exhibit 19.3 Supply Curve and Supply Schedule for Gourmet Cookies Chapter 19 Pricing Concepts Exhibit 19.3 Supply Curve and Supply Schedule for Gourmet Cookies Notes: Exhibit 17.3 demonstrates the supply curve. At higher prices, manufacturers will obtain more resources and produce more product to sell. LO3

How Demand and Supply Establish Price Chapter 19 Pricing Concepts How Demand and Supply Establish Price Price Equilibrium The price at which demand and supply are equal. Elasticity of Demand Consumers’ responsiveness or sensitivity to changes in price. Notes: The concepts of supply and demand are combined to see how competitive market prices are determined. 3

Exhibit 19.4 Equilibrium Price for Gourmet Cookies Chapter 19 Pricing Concepts Exhibit 19.4 Equilibrium Price for Gourmet Cookies Notes: Exhibit 17.4 shows how an equilibrium price is reached when supply and demand are equal. A price below equilibrium results in a shortage because the demand is greater than the available supply. A shortage puts upward pressure on price. At a price above equilibrium, the demand is less than the available supply, and a surplus is created. A surplus lowers the price. Establishing an equilibrium price may not be possible all at once. Prices may fluctuate as the market for a good moves toward equilibrium; however, demand and supply will eventually settle into the proper balance. LO3

Elasticity of Demand Elastic Demand Chapter 19 Pricing Concepts Elastic Demand Consumers buy more or less of a product when the price changes. Inelastic Demand An increase or a decrease in price will not significantly affect demand. Notes: 1. To appreciate demand analysis, the concept of elasticity should be understood. Unitary Elasticity An increase in sales exactly offsets a decrease in prices, so total revenue remains the same. 3

Elasticity of Demand Elasticity (E) = Chapter 19 Pricing Concepts Elasticity of Demand Elasticity (E) = Percentage change in quantity demanded of good A Percentage change in price of good A If E is greater than 1, demand is elastic. If E is less than 1, demand is inelastic. If E is equal to 1, demand is unitary. 3

Elasticity of Demand Price Goes... Revenue Goes... Demand is... Down Chapter 19 Pricing Concepts Price Goes... Revenue Goes... Demand is... Down Up Elastic Inelastic Up or Down Stays the Same Unitary Elasticity Notes: Elasticity can be measured by observing the changes in total revenue shown on this slide. Discussion/Team Activity: Identify products and/or services which illustrate the elasticity of demand. 3

Factors that Affect Elasticity of Demand Chapter 19 Pricing Concepts Factors that Affect Elasticity of Demand Availability of substitutes Price relative to purchasing power Product durability Notes: Factors that affect elasticity of demand are: Availability of substitutes: When many substitutes are available, it is easy to switch products, making demand elastic. The same is true in reverse, if no substitutes are available. Price relative to purchasing power: If a price is so low that it is an inconsequential part of an individual’s budget, demand will be inelastic. Product durability: Repairing durable products rather than replacing them prolongs their useful life. Thus, people are sensitive to the price increase, and the demand is elastic. A product’s other uses: The greater the number of uses for a product, the more elastic demand tends to be. If a product has only one use, the quantity purchased probably will not vary as price varies. Rate of inflation: when inflation is high, demand becomes more elastic—rising price levels make consumers more price sensitive. Discussion/Team Activity: Discuss examples of price inelasticity and elasticity. Include zero percent automobile financing, the price of vehicle models, cell phone rates, prestige watches, cigarettes, health care, etc. A product’s other uses Rate of inflation 3

The Power of Yield Management Systems Chapter 19 Pricing Concepts The Power of Yield Management Systems Understand the concept of yield management systems LO4

Yield Management Systems Chapter 19 Pricing Concepts Yield Management Systems Yield Management Systems A technique for adjusting prices that uses complex mathematical software to profitably fill unused capacity. Notes: When competitive pressures are high, a company must know when it can raise prices to maximize its revenues. Yield management systems, which were first developed by the airline industry, utilize complex mathematical software to profitably fill unused capacity. Yield management systems have spread beyond the service industries and are used by companies to set prices based on a number of variables. 4

Yield Management Systems Chapter 19 Pricing Concepts Yield Management Systems Discounting early purchases Limiting early sales at discounted prices Overbooking capacity Notes: The software employs techniques such as discounting early purchases, limiting early sales at these discounted prices, and overbooking capacity. 4

Yield Management Systems Chapter 19 Pricing Concepts Yield Management Systems Yield Management Systems (YMS) make it possible for a company to: stimulate demand when demand is low, and maximize profits when demand is high. . An example of the effect of YMS on the customer is that when people on tight budgets buy air fare, they usually accept the inconvenience of planning ahead and staying over on a Saturday night to get cheaper fares. The last-minute planner pays more for their fare and (essentially) subsidizes the cost-sensitive customer 4

Yield Management Systems Chapter 19 Pricing Concepts Yield Management Systems Supply Side of Product or Service High Office block House Airline seat Utilities Sport event Rental car Low Shirt Pencils Food Tropical fish Capital Intensity YMS is particularly applicable when the supply side product or service is characterized as capital intensive and perishable. Perishability SOURCE: “Dynamic Pricing Schemes—Established Supplier Led Pricing—Yield Management,” online at http://www.managingchange.com/hynamic/yieldmgt.htm, accessed November 7, 2007.

Yield Management Systems Chapter 19 Pricing Concepts Yield Management Systems Demand Side of Product or Service High Utilities Highway use Telephone Airline seat Sport event Rental car Mobile phone Low Food Music CD Shirt Office block Laptop House Variability of Demand YMS is particularly applicable when the demand side product or service is characterized with both variability of demand and value. Variability of Value SOURCE: “Dynamic Pricing Schemes—Established Supplier Led Pricing—Yield Management,” online at http://www.managingchange.com/hynamic/yieldmgt.htm, accessed November 7, 2007.

The Cost Determinant of Price Chapter 19 Pricing Concepts The Cost Determinant of Price Describe cost-oriented pricing strategies LO5

The Cost Determinant of Price Chapter 19 Pricing Concepts Varies with changes in level of output Types of Costs Variable Cost Fixed Cost Does not change as level of output changes Notes: Sometimes the importance of demand is ignored when prices are decided, based largely or solely on the basis of costs. Prices set on the basis of cost may be too high for the target market. On the other hand, if prices are set too low, the firm will earn a lower return than it should. Costs should be determined as part of any price determination, in part to determine the floor below which a good or service must not be priced in the long run. 4. Variable and fixed costs are important aspects of price determination. 5

The Cost Determinant of Price Chapter 19 Pricing Concepts The Cost Determinant of Price Average Variable Cost (AVC) – total variable cost divided by quantity of output Average Total Cost (ATC) – total costs divided by quantity of output Notes: To compare the cost of production to the selling price of a product, it is helpful to calculate costs per unit, or average costs. Marginal Cost (MC) – the change in total costs associated with a one-unit change in output 5

The Cost Determinant of Price Chapter 19 Pricing Concepts Break-Even Pricing Profit Maximization Pricing Keystoning Markup pricing Methods Used to Set Prices Notes: Costs can be used to set prices in a variety of ways. Markup pricing is fairly simple. The others—profit maximization pricing and break-even pricing--use more complicated concepts of costs. A description of these methods is shown on the following slides. 5

Markup Pricing Markup Pricing Keystoning Chapter 19 Pricing Concepts Markup Pricing The cost of buying the product from the producer plus amounts for profit and for expenses not otherwise accounted for. Keystoning The practice of marking up prices by 100 percent, or doubling the cost. Notes: Markup pricing is the most popular method to establish a selling price. Instead of using the costs of production to set price, markup pricing uses the costs of buying the product from the producer, plus amounts for profit and expenses. The total determines the selling price. Keystoning is a method based on experience, with many small retailers doubling the cost. Other factors that influence markups are the merchandise’s appeal to customers, past response to the markup, the item’s promotional value, the seasonality of the goods, their fashion appeal, the product’s traditional selling price, and competition. 5

Profit Maximization Profit Maximization Marginal Revenue (MR) Chapter 19 Pricing Concepts Profit Maximization A method of setting prices that occurs when marginal revenue equals marginal cost. Marginal Revenue (MR) The extra revenue associated with selling an extra unit of output, or the change in total revenue with a one-unit change in output. Notes: Profit maximization occurs when marginal revenue equals marginal cost. Marginal cost is the change in total costs associated with a one-unit change in output. Marginal revenue is the extra revenue associated with selling an extra unit of output. As long as the revenue of the last unit produced and sold is greater than the cost of the last unit produced and sold, the firm should continue manufacturing and selling the product. 5

Exhibit 19.7 Costs, Revenues, and Universal Sportswear Chapter 19 Pricing Concepts Exhibit 19.7 Costs, Revenues, and Universal Sportswear Notes: Break-even analysis determines what sales volume must be reached before the company breaks even and no profits are earned. (Its total costs equal total revenue.) LO5

Fixed cost contribution Price - Avg. Variable Cost Break-Even Pricing Chapter 19 Pricing Concepts Break-Even Quantity = Total fixed costs Fixed cost contribution Fixed cost Contribution Price - Avg. Variable Cost Notes: Break-even analysis determines what sales volume must be reached before the company breaks even and no profits are earned. A typical break even model assumes a given fixed cost an a constant AVC. The advantage of break-even analysis is that it provides a quick estimate of how much the firm must sell to break even and how much profit can be earned if a higher sales volume is obtained. Sometimes, however, it is hard to know whether a cost is fixed or variable. Furthermore, simple break-even analysis ignores demand. 5

Other Determinants of Price Chapter 19 Pricing Concepts Other Determinants of Price Demonstrate how the product life cycle, competition, distribution and promotion strategies, customer demands, the Internet and extranets, and perceptions of quality can affect price LO6

Other Determinants of Price Chapter 19 Pricing Concepts Other Determinants of Price Perceived Quality Promotion Strategy Distribution Strategy Competition Stages of the Product Life Cycle Notes: Other factors besides demand and costs can influence price. 6

Stages in the Product Life Cycle Chapter 19 Pricing Concepts Stages in the Product Life Cycle Introductory stage – prices high Growth stage – prices stabilize Maturity stage – price decreases Notes: See Chapter 11 for a review of the Product Life Cycle. As a product moves through its life cycle, the demand for the product and the competitive conditions change: During the introductory stage, prices are set high to recover development costs. Demand originates in the core of the market and is relatively inelastic. As the product enters the growth stage, prices tend to stabilize due to the increased product supply from competitors, increased product appeal to a broader market, and decreased costs from economies of scale. Maturity brings about further decreases in price, as competition increases and high-cost firms are eliminated. However, distribution channels become a significant cost factor because of the need to offer wide product lines. Usually, only the most efficient manufacturers remain. The decline stage may see further price decreases until only one firm is left in the market. At that time, prices begin to stabilize and may even increase as the product moves into the specialty goods category. Discussion/Team Activity: Identify and discuss products in various stages of the product life cycle. Relate the pricing of these products to the product life cycle shown above. Decline stage – price decreases 6

The Competition High prices may induce firms to enter the market Chapter 19 Pricing Concepts The Competition High prices may induce firms to enter the market Competition can lead to price wars Notes: Competition varies during the product life cycle. Although a firm may not have competition at first, the high prices obtained may induce other firms to enter the market. Sometimes competition can lead to price wars. 6

Distribution Strategy Chapter 19 Pricing Concepts Manufacturers Wholesalers/Retailers Offer a larger profit margin or trade allowance Use exclusive distribution Franchising Avoid business with price-cutting discounters Develop brand loyalty Sell against the brand Buy gray-market goods Notes: Adequate distribution for a new product can be obtained by offering a larger-than-usual profit margin to distributors, or by offering a large trade allowance to defray the costs of promotion. However, some distributors use selling against the brand strategies to promote their own private-label brands. They place well-known brands one the shelf at high prices next to other brands—usually private label brands—at lower prices. Distributors may also go outside traditional channels and buy “gray-market goods” at lower prices so they can sell the goods with a large markup or at a reduced price. 6

Distribution Strategy Chapter 19 Pricing Concepts Distribution Strategy Selling against the brand Stocking well-known branded items at high prices in order to sell store brands at discounted prices. 6

The Impact of the Internet Chapter 19 Pricing Concepts The Impact of the Internet Shopping Bots A program that searches the Web for the best price for a particular item. Internet Auctions Business-to-business auctions are likely to be the dominant form of online auctions in the future. Notes: The Internet connects sellers and buyers quickly, and allows product and price comparison, putting them in a better bargaining position. Shopping bots search the Web for the best price. The two types of shopping bots are broad-based types and niche-oriented types. Most shopping bots give preferential listings to e-tailers who pay for the privilege, and not necessarily the lowest-priced retailer. Internet auctions, such as eBay, are huge. Business-to-business auctions are likely to be the dominant form in the future. 6

Chapter 19 Pricing Concepts Promotion Strategy Price is often used as a promotional tool to increase consumer interest. Examples: Pittsburgh Zoo – $5 admission for wearing a tie-dye shirt Crested Butte Ski Resort – free skiing between Thanksgiving and Christmas Bugle Boy – uncut competition by offering pants to retailers at wholesale prices Source: The Associated Press, “Sporting a Mullet Pays off at Pittsburgh Zoo,” Boston Herald, July 6, 2010, www.bostonherald.com/news/offbeat/. 6

Demands of Large Customers Chapter 19 Pricing Concepts Demands of Large Customers Require suppliers to pay cash rebates if stores’ profit margins aren’t met. Fines for violations of ticketing, packing, and shipping rules. Notes: Manufacturers find that their large customers often make specific pricing demands that the suppliers must agree to. 6

The Relationship of Price to Quality Chapter 19 Pricing Concepts The Relationship of Price to Quality Prestige Pricing Charging a high price to help promote a high-quality image. Online Vivre vs. Bluefly Vivre is a luxury lifestyle catalog and Web site. Visit Vivre.com and review the product offerings. Pick a product and then see if you can get it cheaper at Bluefly.com, a luxury brand discounter. What luxury brands are offered on both sites? How do the prices compare? Can you identify tiers of luxury brands? Notes: When a purchase decision involves uncertainty, consumers tend to rely on a high price as a predictor of good quality. Consumers assume that “you get what you pay for.” Prestige pricing takes these consumer attitudes into account when devising price strategies. A successful prestige pricing strategy requires a retail price that is reasonably consistent with consumers’ expectations. 6

Dimensions of Quality Ease of use Versatility Durability Chapter 19 Pricing Concepts Dimensions of Quality Ease of use Versatility Durability Serviceability Performance Prestige Notes: In a recent study to ascertain the dimensions of quality revealed the factors shown on this slide, in order of importance, beginning with ease of use. When consumers focused on prestige and/or durability to assess quality, price was a strong indicator of perceived quality. Price was less important as an indicator of quality if the consumer was focused on any of the other four dimensions of quality. 6

Acid+All – Pricing Concepts Chapter 19 Pricing Concepts Chapter 19 Videos Acid+All – Pricing Concepts What role do the product life cycle, competition, and perceptions of quality play in Acid+All’s suggested retail price? http://www.cengage.com/marketing/book_content/1439039429_lamb/company_clips/ch19.html